Lehman Brothers Was Dramatically Over Valuing Its CDOs

Can we take a step back from the details of Repo 105 to point out
the deeply annoying fact that we still do not have a satisfactory
answer as to how Lehman Brother appears to have lost $150 billion
between June and September 2008?

Yves Smith at Naked Capitalism
points out that on May 31 Lehman reported a net worth of $26
billion. The bankruptcy administrator put the total losses at
$130 billion after the collapse. So what the heck happened?

One possibility is that the disorderly collapse of Lehman caused
additional losses. But, as Yves points out, the bankruptcy
adminsitrator says the maximum disorderly unwind cost was $75
billion. That leaves us with an unexplained $75 billion loss.

So what really went wrong? What punched a hole that big in the
balance sheet?

It's hard not suspect that Lehman was just carrying lots of
assets at inflated values. Indeed, the bankruptcy examiner's
report spells out in detail the lack of internal accounting
controls on the values of Lehman's CDO portfolio. Inside of
Lehman, there was a unit called the Product Control Group whose
job it was to double-check the valuations of assets held by
trading desks. As the report makes clear, they did a terrible job
of this.

"When the examiner compared Lehman’s marks on these lower
tranches to more reliable valuation estimates, it found that the
prices estimated for the C and D tranches of Ceago securities are
approximately one‐thirtieth of the price reported by Lehman,"
Partnoy writes. "One thirtieth? These valuations weren’t even
close."

The bankruptcy examiner did not come close to attempting to
valuing all of Lehman's positions, so we do not know how
widespread the misvaluation was. But what we know certainly
proves that Lehman critics, such as David Einhorn, were
absolutely write to question Lehman's accounting.

"The Repo 105 section of the Lehman report shows that Lehman’s
balance sheet was fiction. That was bad," Partnoy writes. "The
Valuation section shows that Lehman’s approach to valuing assets
and liabilities was seriously flawed. That is worse. For a
levered trading firm, to not understand your economic position is
to sign your own death warrant."